Bunwin Residence

Siem Reap, Kingdom of Cambodia

Getting to Know Accounting

1. Introduction
Accounting is the language of business. It is the system of recording, summarizing, and analyzing an economic entity's financial transactions. Effectively communicating this information is key to the success of every business. Those who rely on financial information include internal users, such as a company's managers and employees, and external users, such as banks, investors, governmental agencies, financial analysts, and labor unions. These users depend upon data supplied by accountants to answer the following types of questions:

Is there enough cash to meet payroll needs? How much debt does the company have? How does the company's net income compare to its budget? What is the balance owed by customers? Has the company consistently paid cash dividends? How much income does each division generate? Should the company invest money to expand?

Is the company profitable??

Accountants must present an organization's financial information in clear, concise reports that help make questions like these easy to answer. The most common accounting reports are called financial statements.

Page 1 of 6

2. The Accounting Equation

The ability to read financial statements requires an understanding of the items they include and the standard categories used to classify these items. The accounting equation identifies the relationship between the elements of accounting.

Assets. An asset is something of value the company owns. Assets can be tangible or intangible. Tangible assets are generally divided into three major categories: current assets (including cash, marketable securities, accounts receivable, inventory, and prepaid expenses); property, plant, and equipment; and longterm investments. Intangible assets lack physical substance, but they may, nevertheless, provide substantial value to the company that owns them. Examples of intangible assets include patents, copyrights, trademarks, and franchise licenses. A brief description of some tangible assets follows. Current assets typically include cash and assets the company reasonably expects to use, sell, or collect within one year. Current assets appear on the balance sheet (and in the numbered list below) in order, from most liquid to least liquid. Liquid assets are readily convertible into cash or other assets, and they are generally accepted as payment for liabilities. 1. Cash includes cash on hand (petty cash), bank balances (checking, savings, or money-market accounts), and cash equivalents. Cash equivalents are highly liquid investments, such as certificates of deposit and U.S. treasury bills, with maturities of ninety days or less at the time of purchase. 2. Marketable securities include short-term investments in stocks, bonds (debt), certificates of deposit, or other securities. These items are classified as marketable securitiesrather than long-term investmentsonly if the company has both the ability and the desire to sell them within one year. 3. Accounts receivable are amounts owed to the company by customers who have received products or services but have not yet paid for them. 4. Inventory is the cost to acquire or manufacture merchandise for sale to customers. Although service enterprises that never provide customers with merchandise do not use this category for current assets, inventory usually represents a significant portion of assets in merchandising and manufacturing companies. 5. Prepaid expenses are amounts paid by the company to purchase items or services that represent future costs of doing business. Examples include office supplies, insurance premiums, and advance payments for rent. These assets become expenses as they expire or get used up. Property, plant, and equipment is the title given to long-lived assets the business uses to help generate revenue. This category is sometimes called fixed assets. Examples include land, natural resources such as timber or mineral reserves, buildings, production equipment, vehicles, and office furniture. With the exception of

Page 2 of 6

land, the cost of an asset in this category is allocated to expense over the asset's estimated useful life. Long-term investments include purchases of debt or stock issued by other companies and investments with other companies in joint ventures. Long-term

investments differ from marketable securities because the company intends to hold long-term investments for more than one year or the securities are not marketable. Liabilities. Liabilities are the company's existing debts and obligations owed to third parties. Examples include amounts owed to suppliers for goods or services received (accounts payable), to employees for work performed (wages payable), and to banks for principal and interest on loans (notes payable and interest payable). Liabilities are generally classified as shortterm (current) if they are due in one year or less. Long term liabilities are not due for at least one year. Owner's equity. Owner's equity represents the amount owed to the owner or owners by the company. Algebraically, this amount is calculated by subtracting liabilities from each side of the accounting equation. Owner's equity also represents the net assets of the company.

In a sole proprietorship or partnership, owner's equity equals the total net investment in the business plus the net income or loss generated during the business's life. Net investment equals the sum of all investment in the business by the owner or owners minus withdrawals made by the owner or owners. The owner's investment is recorded in the owner's capital account, and any withdrawals are recorded in a separate owner's drawing account. For example, if a business owner contributes $10,000 to start a company but later withdraws $1,000 for personal expenses, the owner's net investment equals $9,000. Net income or net lossequals the company's revenues less its expenses. Revenues are inflows of money or other assets received from customers in exchange for goods or services.Expenses are the costs incurred to generate those revenues.

Page 3 of 6

Capital investments and revenues increase owner's equity, while expenses and owner withdrawals (drawings) decrease owner's equity. In a partnership, there are separate capital and drawing accounts for each partner. Stockholders' equity. In a corporation, ownership is represented by shares of stock, so the owners' equity. is called stockholders' equity or shareholders' equity. Corporations use several types of accounts to record stockholders' equity activities: preferred stock, common stock, paidin capital (these are often referred to as contributed capital), and retained earnings. Contributed capital accounts record the total amount invested by stockholders in the corporation. If a corporation issues more than one class of stock, separate accounts are maintained for each class. Retained earnings equal net income or loss over the life of the business less any amounts given back to stockholders in the form of dividends. Dividends affect stockholders' equity in the same way that owner withdrawals affect owner's equity in sole proprietorships and partnerships.

Page 4 of 6

3. Financial Reporting Objectives

Financial statements are prepared according to agreed upon guidelines. In order to understand these guidelines, it helps to understand the objectives of financial reporting. The objectives of financial reporting, as discussed in the Financial Accounting standards Board (FASB) Statement of Financial Accounting Concepts No. 1, are to provide information that:

1. Is useful to existing and potential investors and creditors and other users in making rational investment, credit, and similar decisions; 2. Helps existing and potential investors and creditors and other user to assess the amounts, timing, and uncertainty of prospective net cash inflows to the enterprise; 3. Identifies the economic resources of an enterprise, the claims to those resources, and the effects that transactions, events, and

4. Internal Control
Internal control is the process designed to ensure reliable financial reporting, effective and efficient operations, and compliance with applicable laws and regulations. Safeguarding assets against theft and unauthorized use, acquisition, or disposal is also part of internal control. Control environment. The management style and the expectations of upper level managers, particularly their control policies, determine the control environment. An effective control environment helps ensure that established policies and procedures are followed. The control environment includes independent oversight provided by a board of directors and, in publicly held companies, by an audit committee; management's integrity, ethical values, and philosophy; a defined organizational structure with competent and trustworthy employees; and the assignment of authority and responsibility. Control activities. Control activities are the specific policies and procedures management uses to achieve its objectives. The most important control activities involve segregation of duties, proper authorization of transactions and activities, adequate documents and records, physical control over assets and records, and independent checks on performance. A short description of each of these control activities appears below. Segregation of duties requires that different individuals be assigned responsibility for different elements of related activities, particularly those involving authorization, custody, or recordkeeping. For example, the same person who is responsible for an asset's recordkeeping should not be respon sible for physical control of that asset Having different indi viduals perform these functions creates a system of checks and balances.

Page 5 of 6

Proper authorization of transactions and activities helps ensure that all company activities adhere to established guide lines unless responsible managers authorize another course of action. For example, a fixed price list may serve as an official authorization of price for a large sales staff. In addition, there may be a control to allow a sales manager to authorize reason able deviations from the price list. Adequate documents and records provide evidence that financial statements are accurate. Controls designed to ensure adequate recordkeeping include the creation of invoices and other documents that are easy to use and sufficiently informa tive; the use of prenumbered, consecutive documents; and the timely preparation of documents. Physical control over assets and records helps protect the company's assets. These control activities may include elec tronic or mechanical controls (such as a safe, employee ID cards, fences, cash registers, fireproof files, and locks) or computerrelated controls dealing with access privileges or established backup and recovery procedures. Independent checks on performance, which are carried out by employees who did not do the work being checked, help ensure the reliability of accounting information and the efficiency of operations. For example, a supervisor verifies the accuracy of a retail clerk's cash drawer at the end of the day. Internal auditors may also verity that the supervisor performed the check of the cash drawer.

In order to identify and establish effective controls, management must continually assess the risk, monitor control implementation, and modify controls as needed. Top managers of publicly held companies must sign a statement of responsibility for internal controls and include this statement in their annual report to stockholders.

Page 6 of 6